A checklist for buy-sell agreements

By Julius Giarmarco

Giarmarco, Mullins & Horton, P.C.

Business owners must know about buy-sell agreements. Without one, a closely held or family business could face substantial financial and tax problems upon an owner’s death, incapacity, divorce, bankruptcy, sale or retirement. A buy-sell agreement makes sense for any business, including corporations, LLCs and partnerships. This article will outline the purposes for implementing a buy-sell agreement; the types of buy-sell agreements; and the main provisions of buy-sell agreements. It concludes with a checklist to critique an
existing buy-sell agreement.

Purposes of a buy-sell agreement

A buy-sell agreement essentially has three purposes. First, it guarantees a market for a deceased, disabled or withdrawing owner’s stock/membership interests. Otherwise, interests in a closely held business are difficult (if not impossible) to sell. Second, it guarantees the surviving or remaining owners control over the business. Otherwise, the heirs of the deceased, disabled or withdrawing owner could interfere with the business’s operations. And finally, if properly drafted, the purchase price for a deceased owner’s interests (as
determined by the buy-sell agreement) will be binding upon the IRS.

Types of buy-sell arguments

There are three ways to structure a buy-sell agreement. First, in an entity redemption agreement, the business is the purchaser of the interests/membership interests. In such an event, the business would be the owner, beneficiary and premium payer of any life insurance policies funding the buy-sell agreement. Second, in a cross-purchase agreement, the owners are the purchasers of the interests. Accordingly, each business owner is the owner, beneficiary and premium payer of any life insurance policies (on their co-owners’ lives). Finally, in a wait-and-see agreement, the owners wait until a triggering event occurs to determine whether the business, the surviving/remaining owners or both purchase the interests.

Therefore, any life insurance purchased to fund the buy-sell agreement is usually cross-owned by the owners. While the tax consequences to the selling owner are the same under all three types of buy-sell agreements, when a regular C corporation is purchasing the interests, the surviving or remaining owners do not receive a basis increase in their interests. In addition, if a regular C corporation is involved, a 15 percent alternative minimum tax is imposed on any life insurance proceeds received by the business. Therefore, the wait-and-see agreement funded on a cross-owned basis is generally the preferred type of buy-sell agreement.
Three main provisions of a buy-sell agreement

There are basically three parts to a buy-sell agreement. First, those triggering events which result in an owner’s interests being purchased or offered for purchase. Included in triggering events are “force-along” and “tag-along” provisions. For example, when a majority block of stock is being sold, can the selling owners force the minority owners to sell upon the same terms? Conversely, can the minority owners force the selling owners to tag-along on the sale? Second, once the buy-sell agreement has been triggered, the purchase price for the interests must be determined. Finally, once the purchase price has been determined, the payment terms must be established.

Other important provisions of a buy-sell agreement

Besides the triggering events, purchase price and payment terms, there are other provisions equally as important that should be included in every buy-sell agreement. If a corporation has made a Subchapter S election, then language should be included in the buy-sell agreement to protect against an unwanted termination of that election. If the owners do not want a withdrawing owner to compete with the business, especially during the buy-out period when the business may be “providing” the capital for the withdrawing owner’s new venture, the buy-sell agreement should contain a covenant not to compete.

To prevent an owner-employee who is fired from claiming that he/she expected lifelong employment as a result of being an owner, the buy-sell agreement should provide that no owner has an expectancy of employment. The buy-sell agreement should also permit an owner who has been bought out the opportunity to purchase any life insurance policies on his/her life funding the agreement — but only after the buy-out is completed.

The buy-sell agreement should allow the owners to transfer their interests to a revocable living trust without triggering the buy-sell agreement. The promissory note and escrow agreement that will be used in the event of an installment sale should be attached as exhibits to the buy-sell agreement, so as to avoid disputes at a later date. Any promissory note made by the business in connection with the purchase of an interest should be made subordinate to existing and future bank financing. Otherwise, such note may hinder the business’s ability to borrow funds for business purposes. Finally, the buy-sell agreement should contain language accelerating any payments due a selling owner if the business sells all or substantially all of its assets, pays excessive dividends or salaries, or engages in similar activities outside the ordinary course of business.
The following is a checklist to help you review and critique an existing buy-sell agreement.

4. Disposition of life insurance policies upon death of an owner or termination of agreement? _____ Yes _____ No

5. Are transfers to living trusts allowed? _____ Yes _____ No

6. Are the promissory note and escrow agreement attached as exhibits to the agreement? _____ Yes _____ No

7. Are any promissory notes made by the business pursuant to the buy-sell agreement subordinate to bank financing?
_____ Yes _____ No

8. Does the buy-sell agreement call for acceleration of the promissory note if the business takes action outside the ordinary course of business (a sale of all or substantially all of its assets or the payment of excessive salaries to the remaining or surviving stockholders)?
_____ Yes _____ No